A Broader Verdict on Fed's Monetary Policy: It Worked

The Register Guard (Eugene, OR), June 30, 2011 | Go to article overview

A Broader Verdict on Fed's Monetary Policy: It Worked


Byline: GUEST VIEWPOINT By Mark Thoma and Tim Duy

A June 23 guest viewpoint by Phillip Romero and Riaan Nel discussed the Federal Reserve's large-scale asset purchase program - the second round of quantitative easing, popularly known as QE2. The commentary contained a number of misconceptions about monetary policy that might interfere with people's ability to gauge the success of the Federal Reserve's actions during the crisis.

The first potential misunderstanding is about how monetary policy affects the economy. Traditionally, the Federal Reserve eases monetary policy by lowering short-term interest rates. This reduces the cost of borrowing and stimulates economic activity.

But what if, as now, short-term interest rates are already near zero and cannot be lowered further? Does this mean there's nothing the Fed can do to help the economy?

Fortunately, there are other ways for monetary policy to stimulate economic activity. When policy is eased, it also raises the price of stocks and other assets, weakens the value of the dollar, and changes expectations of future inflation. In addition, even when short-term rates are near zero, there can still be room to lower long-term rates.

Romero and Nel discuss only the interest rate channel, and state that "many consider quantitative easing a failure." But when all of the ways monetary policy can affect the economy are taken into account, it's clear the policy worked.

QE2 raised asset values, leading to an increase in wealth and a noticeable effect on consumption. It reduced equity volatility and narrowed corporate bond spreads, and thus played an important stabilization role. And the downward pressure on the exchange rate encouraged exports.

The authors also cite high unemployment as evidence QE2 failed, but this is due to a second misunderstanding. If the unemployment rate would have been even higher without the policy - as the evidence suggests - then the policy was successful even if unemployment remains relatively high.

This brings us to a third misconception. To gauge the success of a policy, it has to be measured against the policy goals. Although QE2 did stimulate economic activity, the primary goal was to prevent deflation, as Fed Chairman Ben Bernanke made abundantly clear in his last press conference. By this measure, the program was a smashing success. Inflation expectations - as measured by 10-year inflation-protected Treasury securities - had plunged to 1.49 percent before the Fed's actions last fall, and subsequently rebounded as high as 2.64 percent.

Yet another misconception is the authors' contention that money created by the Fed has "flowed into less productive assets, especially overseas. …

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